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Why the Japanese Yen Has Triggered Global Concern

The Japanese government was criticized for deliberately weakening the Japanese yen by German Chancellor Angela Merkel during a question-and-answer session following a speech at the World Economic Forum in Davos, Switzerland.

"I can't say I'm completely free of worry when I look at Japan right now," Merkel said, according to Bloomberg News.

Michael Meister, a senior member of Merkel's Christian Democratic Union who will be meeting with Japanese officials next month, said in a telephone interview with Bloomberg, "What can Japan's competitors do? Either we're all smart and do nothing, or we follow suit and create a spiral that hurts us all."

"The Japanese economy's real problems are structural and beg structural remedies, not tampering with the exchange rate," Meister continued.

Merkel and Meister are not the only German critics of Japanese Prime Minister Shinzo Abe's program to revive the Japanese economy through weakening the yen.

Meanwhile, South Korean Finance Minister Bahk Jae Wan said South Korean exporters, which compete directly with Japanese companies in many industries, including cars, electronics and engineering, might be "at risk."

Deng Yuhan, writing for China's Xinhua News, said, "The easing of Japan's monetary policy entails the weakening of its currency, a side effect – if not the purposeful design – that can translate into an artificial and unfair price advantage for Japanese exports."

Deng continued, "It is a safe bet that others would respond with driving their own currencies down, thus igniting a downward race among the world's most heavily traded media of exchange – known in a more dreadful way as currency wars."

Weakening Japanese Yen and Exports

Japan reported trade data early Thursday for December 2012 that encouraged these currency war fears.

The data showed exports down a worse-than-expected 5.8% year-on-year while imports were up 1.9%, largely reflecting the weaker Japanese yen. Liquefied natural gas (LNG) imports were up by 8.1% in December.

LNG imports have risen sharply since the March 2011 earthquake and nuclear accident resulted in the shutdown of all but two of Japan's nuclear power plants. Japan currently generates most of its electricity from thermal power plants that burn LNG.

Exports to the U.S. were down 0.8% in December while shipments to Europe were off by 11.1% as the sovereign debt crisis drags on there. Exports to China, Japan's biggest trading partner, were down 15.8%, reflecting both a slowdown in the Chinese economy and deteriorating relations between the two countries over a territorial dispute.

The weaker yen also has pushed Japanese stock prices higher and there have been numerous news stories about how Japanese retail investors – known collectively as "Mrs. Watanabe" – are starting to put more of their money into offshore investments again.

Prime Minister Shinzo Abe: Yen Master

Prime Minister Abe has been an absolute master at getting the financial markets to do all the heavy lifting in weakening the Japanese yen.

Abe's persistent calls for "unlimited monetary easing" and an "end to deflation" both during the Lower House election campaign last month and in the weeks since he has become prime minister have resulted in the yen weakening by about 11.8% against the U.S. dollar from 79.46 to 90.05 today.

Julian Brigden, managing partner of MI2 Partners, observed that Prime Minister Abe has gotten hedge funds and currency traders to weaken the yen simply by telling them what they wanted to hear. The more aggressively – some might say outrageously – Abe talked about unlimited easing and bashing the Bank of Japan into compliance with his 2% inflation target, the more the markets sold the yen.

There is now a massive short position in the Japanese yen. We saw some of that unwound on Tuesday, following the Bank of Japan Policy Board meeting on "disappointment" over the central bank's decision to postpone "unlimited" easing until next year.

In fact, the Japanese have not done anything to overtly weaken the yen. There has been no intervention in the currency markets, just statements from Prime Minister Abe and other senior Japanese officials supporting the weaker – but not too weak – Japanese yen.

The prime minister has taken a page from the book of Eisuke Sakakibara, a former Ministry of Finance official known as "Mr. Yen" who, as Brigden put it, "got the hedge funds on his side."

He who lives by the hedge funds, dies by the hedge funds too. Abe, like Sakakibara before him, has the hedge funds on his side now. But he has to keep feeding them the raw meat they need to keep their yen shorts on or else face a sudden reversal in the exchange rate.

The correction we saw on Tuesday in the wake of the BOJ Policy Board decision was temporary because the market is now waiting for Abe to name his candidate to succeed the outgoing BOJ governor and vice-governor.

Clearly, the market is looking for someone who is fully on board with Abe's reflationary policies and who will take the necessary "bold monetary easing" to defeat deflation. The next BOJ governor is also going to have to convince his wary central bank colleagues around the world that Japan is not trying to start a currency war by weakening the Japanese yen.

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